BERNANKE'S CHOICE; What's a Fed Chairman to Do?

By ALEX BERENSON

Published: August 5, 2007

PAUL VOLCKER faced a recession and double-digit inflation when he became chairman of the Federal Reserve in 1979. Alan Greenspan took over the Fed in 1987 and two months later ran into the worst market crash since the Depression.

Now Ben S. Bernanke, who took the Fed chairmanship in February 2006, is facing his own problems. Compared with the crises that Mr. Volcker and Mr. Greenspan encountered, Mr. Bernanke's troubles are relatively minor, at least for now. After years of easy credit that fueled a boom in takeovers and mortgages, the debt markets have abruptly tightened. Consumers with weaker credit are paying higher rates for loans if they can get them. Businesses, too, find financing more difficult.

The end of cheap credit may be overdue. In the last few years, Wall Street has taken advantage of cheap money to make loans and finance takeovers that may not have made economic sense, said Robert DiClemente, chief United States economist for Citi -- formerly called Citigroup.

''At the core this is a healthy adjustment,'' Mr. DiClemente said.

But the speed with which credit markets have tightened is unnerving, rippling through the financial markets for stocks and bonds and sending investors into retreat. ''I'm a little nervous that this could be a brush fire that could get out of hand,'' Mr. DiClemente said.

The Fed meets on Tuesday, and Mr. Bernanke must decide whether to allow the credit crunch to play out on its own or to step in by lowering interest rates.

The right answer is not obvious, said Jared Bernstein, senior economist at the Economic Policy Institute, a liberal policy group. William McChesney Martin, the Fed chairman from 1951 to 1970, memorably said, ''The job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting.''

In other words, the Fed needs to set interest rates high enough to prevent the economy and markets from becoming overheated, but not so high that they dampen economic growth unnecessarily.

The Federal Reserve's power over the economy and Wall Street can be overstated. The Fed cannot improve business productivity or force lawmakers to create sensible tax policies or make investors act prudently -- all important ingredients for long-run economic growth.

But the Fed has vast influence over short-term swings in the economy through its control of interest rates. The short-term rates set by the Fed now stand at 5.25 percent annually. By lowering rates, the Fed makes borrowing easier, giving a boost to the economy.

Raising rates has the opposite effect, slowing businesses, consumers, and investors if the economy appears to be in danger of overheating and igniting inflation. The Fed can also use regulations and jawboning to encourage or discourage banks from lending.

The biggest blight on Mr. Greenspan's tenure as Fed chairman is the technology stock bubble of the late 1990s, which led to the plunge in the Nasdaq index between 2000 and 2002. Mr. Greenspan was partly at fault for that bubble, Mr. Bernstein said, because he allowed markets to believe that he would always make credit available if they ran into trouble.

By taking a firm line in the current credit crunch, Mr. Bernanke can show investors that they cannot count on the Fed to save them from market swings, Mr. Bernstein said.

''This would be a good time for the Fed to impose some discipline on financial markets that we haven't seen in a while,'' he said.

But, in an illustration of the fine line that Mr. Bernanke must walk, Mr. Bernstein said he hopes the Fed considers lowering interest rates this fall, not to help Wall Street and hedge funds, but to lower the risk of an economic slowdown that would hurt middle-income Americans. With core inflation, excluding food and energy, running under 2 percent annually, the Fed has room to lower rates, Mr. Bernstein said.

In essence, Mr. Bernanke faces a choice of keeping credit relatively tight for now -- and thus reducing the risk of bubbles for years to come -- or loosening credit and lowering the chance of an economic slowdown in the next few months.

Ed Yardeni, the president of Yardeni Research, said he had little doubt what choice Mr. Greenspan would make if he were still in charge.

''Under Greenspan, my guess would be that the Fed would be already talking about priming the markets for a possible easing,'' Mr. Yardeni said -- through lowering of interest rates. ''Under Greenspan, there was a modus operandi where the Fed would respond to potential shocks to the economy even if they had low probabilities.''

But Mr. Greenspan is not in charge anymore. Mr. Bernanke is, and he appears to be more inclined to allow the credit crunch to play out on its own, Mr. Yardeni said.

If Mr. Yardeni's hunch about Mr. Bernanke is correct -- and most investors seem to believe that it is -- the Fed will keep short-term rates at their current levels for at least a couple more months.

Is that strategy the right one?

We'll know soon enough.

Photos: THE DECIDER The economy is slowing, and Ben S. Bernanke must determine the Fed's course. (Photograph by Alex Wong/Getty Images)